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Friday, December 9, 2011

Transcript 477: Will the Euro Survive? Wrong Question.

Today we return briefly to the podcast on the eve of the non-answer from the European heads of state. It must be a non-answer because it responds to the wrong question.

The question? “Will the euro survive?” Wrong question, since the euro could survive as the currency of a stable economic union or it could survive as the smoke above the rubble.
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The real question is the debt. Enormous financial obligations have been incurred that cannot be paid back. Households and businesses and governments. Businesses somewhat less so because policy-makers have made the borrowing in that sector cheaper as one of their ineffectual ways of addressing problems that are not addressed by making borrowing for businesses cheaper.

These financial obligations are the liabilities of households and governments and the assets of the financial sector, investors and banks. Because they cannot be paid back, investors will lose money and banks will go under. Though there is the hope the governments can be persuaded or coerced into paying off at 100 cents on the dollar. And that is where we are now.

In the U.S. it was the Fed buying up trillions in mortgage backed securities and other financial instruments while at the same time financing banks and their traders at zero percent, even as the social safety net absorbed millions of people thrown out of work to make way for a corporate sector as profitable as it has been since …. well, it has never been more profitable. The current call is for the European Central Bank to follow suit, and the taxpayers of Europe to follow the lead of their American counterparts.

Why will these debts not be paid back? Because they cannot be paid back. Why can they not be paid back? Because there is no productive source from which to pay them back. They did not finance productive assets. They financed consumption and housing bubbles. Just like in the U.S. when a housing bubble produced massive paper wealth exactly because it was financed by debt. In the clear light of morning, when the value of housing as housing becomes the source of house payments, trillions of dollars in housing as a financial asset disappeared, leaving trillions of dollars in debt on household balance sheets for which there was no asset to balance. All that paper wealth and all that consumption is behind us. Just like the financial asset part of housing. Those dollars have been spent. Only the debt remains.

As Minsky taught us, we have productive finance – what he called “hedge”, we have rollover finance – what he called “speculative”, and we have Ponzi finance – his term. We floated our economies from 2000 to 2007 by building the debt. Now it’s time to pay the piper. But in a macroeconomic sense, unless there is a productive source, payback will appear as contraction, which will actually contract the ability to pay. The piper is going to have to be paid back with the memory of his own music.

So, let’s leave aside the necessary and essential ways of dealing with this debt – writing it down or taxing the winners to pay it off – and let’s look at what is happening in the Euro Crisis. Fundamentally, the banks and bond vigilantes are demanding action and the political establishment has been called in as enforcers. Enforcers of an austerity, the contraction of economies, starvation as opposed to production. Now it appears the banks and bond vigilantes need German control of all national budgets by the middle of next month. Such is the desperation.

This does not mean that the debts won’t be shifted by this action. Indeed, that is the purpose. To shift the assets from the banks who hold them to the taxpayers or central bank. But they won’t be repaid unless there is growth in value with which to repay them. Or unless the winners from the whole boom are taxed to pay them. Right now it is a scramble for the best fitted vigilantes to keep their Ponzi gains at the expense of the rest.

A parenthetical:

The Mundell Trilemma, aka the Unholy Trinity.

Robert Mundell proposed that a country can have any two of the following three options
  • A stable exchange rate
  • Free capital flows
  • Economic sovereignty

Here we have the Eurozone on the horns of this trilemma. The euro provides exchange rates that do not vary because there is only one. The Eurozone free capital flows washed in and are washing out. And the only answer everyone agrees upon is for nations to give up their taxing, interest rate, and spending decisions to some as-yet-unidentified fiscal general.

But the point is – It still doesn’t work. The idea that austerity or German prudence can produce net gains from which profligate German banks can be paid back is just wrong. There is no example of its working, and God knows the IMF has tried it everywhere. Abandoning the euro by a country such as Italy or Spain allows them to write down their debt by unilaterally re-denominating it in the domestic currency. The same thing could be done by a simple haircut in euros. Saves the euro, stabilizes economies, gets things going again.

But the banks don’t survive, either the collapse of the euro and the debts being recalibrated in domestic currencies, or a simple write-down of debt to payable levels, referred to by hysterical traders as a default. The whole Rube Goldberg financial sector contraption comes apart sooner or later, notwithstanding the fact that it has already begun to seize up. Bond investors, hedge funds, banks, all connected by a series of speculative financing structures, comes apart.

Well, that is what happens. Sooner or later. It’s just a case of a forty-pound parasite on a fifty-pound dog.

And before we leave, we should remember we saved the banking sector only a couple three years ago, absorbed its bad housing bets, bridge-loaned even the most egregious speculators – think Goldman Sachs – and set it up to continue doing what it was doing before. All in the name of “Banks first, economy to follow.” It was an explicit quid pro quo that turned into a failed experiment, or at least an experiment in failure. In fact, the experiment did produce the positive knowledge that socializing banking and investor losses doesn’t avert subsequent crises, nor does it lead the real economy back into the light.

The world and the U.S. economies are broken. The fixes are not cosmetic. Current plans to address the problems are ineffectual, or in the case of austerity actually are making matters worse. The policy-makers in thrall to an establishment continue to muddle around in a circus of impotence. Their economic theory is contradicted by events, predicts nothing, diagnoses nothing. It is run up as backdrop to the press conferences of banking and political establishments, but no longer expressed out loud. The diagnosis of a nervous condition, even as the bloodstains spread on the blankets, is malpractice. In the case of the Fed, administering blood thinners to a hemophiliac, it is worse.

On one hand you have a tepid recovery – what we at Demand Side call bouncing along the bottom – which orthodox apologists actually cite as evidence of some sort of success. On the other hand you have massive government deficits and ridiculously low interest rates, which are, in turn, cited as evidence of government being the problem and bankers doing what is necessary. GDP growth is barely above a flat line, in spite of these historically unprecedented interventions. This is not a sign of health or even stability. it is a sign of an economy on life support.

The real economy’s muscular and skeletal systems are atrophying as the patient lies abed. The labor market continues to shrink, jobs continue to deteriorate, median incomes continue to fall, infrastructure continues to crumble, environmental systems continue to decay, education continues to be hollowed out, health care continues to be too costly and not effective, and the transition to a sustainable future for an aging population is being pushed away, rather than brought forward.

Parenthetically, the looming climate crisis is likely to be annotated by the establishment in the same way as the financial crisis – “Why didn’t the government do something? Not our fault.” Well, government didn’t do something because you control government and you told them not to do anything.

Just to highlight how far we are from substantive measures, look at the current fight in Congress over the payroll tax. Obama and the Democrats want to extend the payroll tax cut for another year, at the cost of $180 billion. That’s gross. Net would be less, as some tax revenue will accrue. But what if they hired 4 million people at $45,000 per? They could do things we desperately need to have done. The job multiplier would add at least 3 million more. Income stagnation for the rest of us would end. Same cost. End of unemployment problem. It’s all very well and good to goose consumption for the middle class, I suppose, but it is not job holders who are suffering the most, and it is not by adding another consumer discretionary to the pantry that we are going to get out of this mess.

Is it better than nothing? Not if it is advertised as a solution when it is a placebo. Seven million jobs is direct pressure over a gaping wound.

Before we leave today, look on the blog for a couple of charts.

One from Calculated Risk shows the drop in household wealth. From 2007 to Q3 2011, a loss of about 100 percent of GDP. Nothing more clearly illustrates the bubbles of the 1990s in stocks and of the 2000s in housing. Nor does anything illustrate so well the Ponzi nature of this wealth. Hidden is the difference between debt and so-called equity, the definition of net worth. The debt is sliding a bit, but not as fast as the equity, and so we go into debt deflation.

The second chart taken off Bloomberg is an update of our bunny hops in commodity markets. We noted a couple of months ago the improbably regular pattern of mini-boom and bust that has marked this casino table. Since the peak of the commodities bubble back in April, there has been a two-month cycle, until the past few weeks.

The regular pattern would have us continuing down toward a negative ten in the index, or about $80 per barrel in oil. Not so quick, say the traders. We need some place to play now that Europe is needing the house to clean up our mess. A blip up. The end of the year will be interesting. Commodities are flat for the year, in spite of the 20 percent rise from January to April.

Happy gaming.

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